Following the Crowd: Why we do it?

I love this clip from the classic 1960’s TV show ‘Candid Camera’. It rather amusingly emphasizes the way we as humans are prone to conform to crowd behaviour. There are many reasons for this, and it’s helpful to understand these when we try to understand markets, and our own behaviour within markets.

We all like to think we are independent thinkers basing our decisions on sound logical and rational choices. - However, this is not really how the real world works. - I am minded of a hedge fund client last year who lost a lot of money when the Swiss National Bank surprisingly devalued the Swiss Franc against the Euro. - He had actually wanted to be short of the Swiss Franc, which would have made him a lot of money, but instead was heavily influenced by the fact that all the senior portfolio managers around him, and the head of the firm, were the other way around. Thus he overruled his own analysis, and went with their view. Which subsequently came at a heavy price. - For those who have never experienced life in a trading room, this is far more common than you think. 

The Keynesian Beauty Contest

No matter how much we know, we are actually quite limited in our knowledge, and we know that, but only at a subconscious level: In financial markets, we can only ever have partial knowledge of all the relevant facts, thus 'subconsciously' we assume the crowd has far more knowledge collectively than us, and thus take notice of what they think. As a consequence, we submit a degree of our decision-making to the crowd, or at least the crowd that we belong to. This does not mean the crowd is always right of course, but that is not the point, the point is that we are heavily influenced by the crowd. As if to emphasise this, just take a look at the performance of Hedge Funds in recent years: They are considered the 'Alphas' of the investment world, yet since 2011 the US stock market is up around 70%, whilst US equity funds as a group are down close to 10%. Equity Hedge Funds have been herding around a bearish view for some time, Barry Ritholz discusses this in his recent article 'When “Fringe” Sentiment Dominates Psychology'. Jon Maynard Keynes first identified this when he compared the way investors pick stocks to how one could develop an approach for picking winners of a newspaper beauty contest (of the type common in the 1930s). In these contests, pictures of women would be displayed in a newspaper. The most popular selection picked by readers would be declared the winner. A prize would go to one reader, selected at random, from those who voted for the most popular choice.

"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees." 

(Keynes, General Theory of Employment, Interest and Money, 1936). 

This can help us understand why markets trend rather than just jump to a new level of value. Personally I can not think of a better reason to buy a stock than the belief that everyone else will be buying it. - On the other hand, when we are long of something and it is moving the other way, our negative emotional response is not just because we are wrong, it is also because we are feeling a little uncomfortable being against the crowd. The emotional response we are having at that point is not a choice we make, it is chosen for us by our ancient nervous system. - This happened because as a species we are social beings: Our ancestors learned to cooperate, share and be mutually dependent on each other, this greatly increased their chances of survival. Those ‘conforming individuals’ were the ones who came to pass on their DNA. Those who did not conform were more likely to be rejected by social groups. These 'rejects' would have to fend for themselves in the harsh natural environments our ancestors inhabited, which could mean almost certain death.  If you ever wondered where our innate 'fear of rejection' stems from, there is your answer. - For 'Fear of Rejection' also see 'Fear of Missing Out' or FOMO.

What about contrarians?

Fortunately as humans we are not completely hostage to our emotions, we do have the ability to 'learn' to temper our feelings, which allows us to modify our behaviours. Contrarians have become particularly adept at this. They are able to spot patterns where the crowd inevitably reaches an extreme. In trading, there is always an extreme for momentum, a point where the trade is crowded. At this point, if enough people exit together, the momentum turns the other way, sometimes with great rapidity. - Being a contrarian is an art, I know people who are always contrarian, they wait until they think the market is overextended then fight it. Many successful traders have made a career out of being contrarians, sometimes dicing dangerously with 'capital/liquidity death' along the way.

Good momentum traders on the hand prefer to go with the crowd. They are able to run with the momentum, and exit in a timely manner just as the contrarians are sharpening their claws. Good contrarians are excellent at picking extremes in the momentum, but bad contrarians actually help the trend, selling into a rising market not ready to turn, but then being forced to buy back at a higher level.

Successful trading and investing requires understanding not just the behaviour of the crowd (the market), but also a degree of knowledge of why as a trader you act and behave in certain ways. Successful traders develop behaviours which promote better decision-making, and counteract the negative and subconscious aspects of trading which so undermine performance.

By Steven Goldstein

Alpha R Cubed Ltd

Alpha R Cubed delivers cutting edge 'Behavioural Performance Coaching Programmes' which help traders and investment professionals learn more about their own 'Behavioural Biases'. Our powerful programmes facilitate people to transform their behaviours, leading to significantly enhanced performance and far stronger returns. If you would like to know more about our programmes, please click on the image below, or email me steven.goldstein@alpharcubed.com or at info@alpharcubed.com. Visit us at www.alpharcubed.com to learn more.

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